Pension incomes set to shrink
The amount of money people can earn from their pension annuity is set to fall sharply over the next year as a result of the economic downturn coupled with longer life expectancy.
For most of 2008 annuity rates have looked extremely competitive, actually hitting a six-year high earlier in the year. This trend has been driven by increased competition among insurers as well as attractive yields from corporate bonds, which are used to price annuity products.
However, according to annuity experts at Hargreaves Lansdown, the last few months have seen annuity rates fall back slightly with insurers less keen to pass on the full benefit of good corporate bond yields. Now, as the UK hovers on the brink of a recession, annuity rates are expected to experience a sharp fall.
Currently, a 65-year-old male can expect an annuity product paying 7.7% interest – by next year, a 65-year-old male is likely to earn less than 7% from his annuity.
Corporate bonds, as well as gilts, are used by insurers to fund annuities. The credit crunch has given the corporate bond sector a boost, with yields reaching unprecedented levels. However, the government’s banking bailout, designed to get institutions lending to each other again on the credit market, is expected to have a negative effect on bond yields, putting downward pressure on annuity rates.
Nigel Callaghan, pensions analyst at Hargreaves Lansdown, says: “In August it looked as though annuity rates may have come off the peak, with seven leading insurers reducing rates. The market mayhem during September and early October may have temporarily stopped the slide but widespread expectations still point to falling bond yields over coming months.”
The fact that inflation is believed to have peaked is also bad news for annuity rates. Lower inflation tends to reduce corporate bond yields, thus depleting the investment returns insurers use to pay annuity income.
In addition, increasing life expectancy is also putting pressure on annuity rates, as insurers are concerned about having to pay out for longer. Increasing numbers of providers are now offering enhanced annuity incomes to people with shorter life expectancies, such as smokers, and those who live in less affluent postcodes (where life expectancy is assumed to be shorter).
With just one pot of money to go round, the consequence of this is less competitive rates for the healthy and wealthy.
Callaghan adds: “Annuities are undergoing a rapid evolution towards an individual pricing approach where the actual rate is dependent on the investor’s health and lifestyle, as seen by the rise of enhanced and postcode annuities. This drags down rates for the healthy and those living in more affluent neighbourhoods.”
Both these factors will, in the medium to long-term, reduce the amount of income retirees can expect to earn from their pension pot.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.